Tuesday, June 15, 2010

I don't want to make too much out of this chart, but it is interesting to see how swap spreads have been leading commodity prices for the past several months; note in particular how swap spreads peaked in late May, followed by a bottom in commodity prices in early June. I've long been a fan of swap spreads as leading indicators, since they are real-time measures of financial market fundamentals such as confidence, fear, systemic risk and general liquidity. Commodity prices, on the other hand, tend to lag, but not by too much since they can be driven not only by economic fundamentals (which don't change as fast as financial market fundamentals) but in many cases by financial market speculation (i.e., via futures) which can change fairly fast.

This relationship does not always hold, however. But right now there is a logical link between swap spreads and risky asset prices due to the fears that have surfaced in regards to the Euro debt crisis. Declining swap spreads over the past three weeks are a good indication that Eurozone risks have not found traction in the U.S. economy, and thus that the Euro debt crisis is not going to morph into a threat to the global economy. As the risk of a double-dip recession recedes, it makes sense for investors to return to risky assets, just as it makes sense for corporations to be more inclined on the margin to undertake projects that require commodity inputs. Swap spreads have also been tightly correlated to equity prices recently, and have tended to lead them as well.

Bottom line: declining swap spreads are pointing the way to higher prices for a variety of risky assets.

Scott,I know you read Panic by Redleaf and Vigilante. I am just getting to it, but my understanding is they are critical of CDS as a measure of risk. Are they criticizing the same swaps spread you mention here?Thanks as always for a great blog.Russ

REW: I don't think they are critical of CDS per se, rather they are critical of the assumption that a CDS market (or any derivatives market) can be efficient or a sign of efficiency. The CDS concept is sound, but the CDS market can be abused, especially if the government gets involved (e.g., tipping the scales, p. 227).

Swap spreads are indeed similar to credit default spreads, in that they are both derivative markets. One big difference, however, is that the swap market is much larger and more generic. A 2-yr swap uses 2-yr T-Notes as its defining security—huge in size—whereas a CDS contract uses a single corporate bond or a basket of corporate bonds as its underlying security.

Nevertheless, I think they would agree that even generic swap spreads can fall victim to inefficiencies. But that doesn't mean they aren't viable.